Why the Yuan’s Decline Matters

A clerk counts Chinese Yuan at a post office in Taipei, Taiwan, February 19.

European Pressphoto Agency

Here’s what happened:

China’s yuan has fallen steadily against the U.S. dollar in the past week. On Wednesday, The Wall Street Journal reported that it wasn’t market forces or traders behind the move, but that the Chinese central bank was deliberately pushing the currency lower. That a central bank would do this on purpose has caught some off-guard, especially since the yuan was long seen by investors as a currency that was only going up.

Why does this matter now? Why are they doing it?

Currently, the yuan trades within a tight range set by the central bank every day. But, short-term traders and increasing demand is almost constantly pushing the currency higher within that range. By denting the currency’s value on purpose, the central bank is trying to spook away these traders who will now have to worry about the possibility China does this again. With fewer “speculators” trading the yuan, China hopes to have an easier path to widen the yuan’s trading range further and, in the much longer term, make the yuan a free-floating currency that’s driven only by economic and market forces.

Why does China want to free its currency in the long term?

Having a freely traded currency opens up a wide door for the yuan to become much more prominent in trade and payments across the globe. Perhaps most importantly to China, a freely convertible currency also makes the yuan a more attractive option for other central banks’ stockpiles of cash, also known as their foreign exchange reserves. Currently the U.S. dollar dominates as the number-one reserve currency in the world—that’s why so many central banks hold U.S. government bonds even when the U.S. economy doesn’t look to rosy. China wants the yuan to challenge the dollar’s long-established role, and gradually freeing its currency is a critical step to get there.

Why else?

China is also trying to push its economy away from relying so much on exports and investment. It, instead, wants more of its growth to come from domestic demand. Making the yuan behave more like a market-driven currency fits into this broader plan.